PTER

corporation's ownership and control are separated between two

parties—stockholders and officers. The stockhdlders own the firm _and
officers (or executives) control tb. firm. A simpleproblem exists with this
- - : -
separation of ownership and control. Why should the managers care about the
owners? Managers may put personal interests first, even at the expense of owners. `This
situation is known as the prIncipol-agent problem or the asency pobleln. The _
shareholders of a Corporation are the principals afiliThe Managers-who run the
company are the agents. If shareholders cannot effectively monitor managers' ,
behavior, then the lattermay be tempted to use the firm's assets to enhance their
-own lifestyles.
Solutions to *agency problems tend to fall in''tivo categories:incentives and
inonitoring, The board of directors, auditors, and other components of the gover-
nance system serve to monitor rnanagers,;. this is discussed in later chapters. The
incentive solution, covered in this chapter, ties an executive's wealth to the
Wealth of shareholders so that everyone shares the same goal. This is called align-
,in executive incentives with shareholders' desires. Managers should then act in
ways that also benefit 'other shareholders. To align manager and shareholder
interests, most executives receive stock options as a_ significant component. of
their compensatiort. In this chapter, we focus on the incentives of modern execu-
tive compensation.

A manager has a variety of stakeholders that are affected by his actions. These
include investors such as stockholders (owners) and lenders, the firm's customers and
suppliers, the firm's employees, and of course himself. A good manager should put the
needs of other stakeholders before his own but human nature may cause him to put
his needs first. Examples of self-serving managerial actions include:
).,a shirking (i.e. not working hard);
hiring fiiends;

11
 Incentives
12 CHAPTER 2 Executive
-
ks (e.g. purchasing extravagent office- furniture,
consuming excessive per using
ng large expense accounts);
company cars, enjoyi
rm as large as possible even, though it
building empires (i.e. mak ing the fi may
re value);
hurt the firm's per sha nd
o avoid bein . fired; a
taking, no risks or chances t e manager
g is near retirement.
having a short-run horizon if th
nagers will not behave in these ways is to give
One way to make sure that ma them
act in the interests of their other stake-
the right monetary incentives to
cutive compensation that are aimed at
holders. We discuss various types of exe
accomplishing this task.

.,-..0'11713ES OF EXECUTIVE COMPENSATibil

rent ways. They receive a basic
Company executives are compensated in many diffe
salary that also includes pension contributions and perqu isites (company car, club
eceive a bonus that is
memberships, and so on). In addition, top executives might r
usually linked to accounting-based performance measures. Lastly, managers might
receive additional wealth through long-term incentive programs, usually in the
form of stock options, which reward the manager for increasing the company's
stock price. Stock grants are another common form of long -term awards.

Base Salary and Bonus

As with most jobs, CEOs are promised a specific annual salary.The base salary of a
company CEO is often determined through the benchmarking methodi'which
SiirVeys peer CEO salaries for comparison.1 Salaries less than the 50th percentile are
considered under market, while salaries in the 50th to 75th percentile are
competitive. CEO base salary has continuously drifted upward because CEOs
typically argue for competitive salaries. So each year we often see CEOs getting nice
raises and also we see new CEOs making more than current CEOs.
Interestingly, this basic pay results more from characteristics of the firm (e.g.
industry, size) than on characteristics of the CEO (e.g. age, experience). So a,. CEO of
a large firm often gets a salary higher than a CEO of a smaller firm, regardless of
the person's past success, age, and experience. Mercer Human Resource
Consulting, in conjunction with the TVall Street Journal, annually sur-
veys proxy statements for 350 of the largest U.S. companies to examine CEO
compensation trends.2 In 2004, the median base salary for CEOs of these large
firms has been about $975,000.".

At the end of every year,,CEOs often receive cash bonuses. The size of the,',

.paY-nientisliased'Odihe'performance of the firm over the past year and is typi -,tally based on the accounting profit measurements of earnings per share (EpSi and
earnings before interest and taxes (EMT). Measures of economic value.' added
(or EVA) are also common. These value-added measures are usually vaii-
atioas on earnings minus the cost of
capital.The idea is to measure the value
-added to the firm, in relation to the firm's costs ofrising different sources of
Stock Options .

Executive stock options are the most common form.ofr.a.arizet,orientd

pay.St..oc options are contracts that allow executives to buy shares o_f stock at a-
.fixed price, called the exercise,or strike pr therefore, if the price of thle stock-
rises above. the strike _price) the executive will capture the differ...nce as a-profit.:r
'or example, if the stock of a company trad.!s at $50 per share, the CEO-may be
given options with a strike price at $50. Over the next few years, if the stock price
rises to $75 per share, then shareholders would receive a 50 percent return on their
stockholdings. The CEO could buy stock for $50 per share by exercising the option
and sell it for $75 per share, thus making a $25 profit on each option owned. If the
executive has options for 1 million shares, then he could pocket $25 million. If the
stock price reaches $100 per share, the executive could cash in for $50 million. In
contrast, if the stock price were to drop to less than $50 per share, then the options
have no exercisable value and are said to be underwater. Executives treat stock
options as compensation; they nearly always exercise the
options to buy the stock and then sell the stock for the cash. Only rarely will an
executive keep the stock. _
Stock options give the executives of the firm the incentive to nimAgt the firm
in-sitch a way that the stock price increases, which is precisely what the stockhold-
ers want as well.Therefore, stock options are believed to align managers' goals with
shareholders' goals. This alignment helps to_ overcome Soave 90,4,..woblerns
the separation of ownership and controllThe typical executive option contract
ng stock price
assigns the strike price of the options to the prevaili when the option is
granted. The most common length of the options Contract is 10 years. That is, the CEO has
10 years to increase the price of-the stock and exercise the optionsAtitaci
or transfer their optio nd are"
10 years the options expire.txecutive,s cannot sell ns a
tiOn-based award
discouraged from hedging the stock price riskjhe median op
Executive stock options
realhed for Cl.!:Os in large firths was $2.7 million in 2004. were
not common prior to 1980.
. r. unting
0.ptiton:; rind A.-mo _.
orniansratiO-n itt.the.US. partlytame_
The popularity of stock options as incentive c from
e company.'Whea-
its favorable tax treatment for both the executive and th
an accounting cost
"options were granted, the company only needed to report
hen the cost was
..,whenthe strike price was less than the current stock price. T
anted with
ilT)01 Liza_ over the lifipt,tlip,vpl,iurlt13,r;cciop.149,avptions were v
 EXAMPLE 2.1

EOs IN 2004 (INCLUDES

TEN HIGHEST PAID C STOCK OPTION GRANTS)
SALARY, BONUS, AND
Schar,
Dwight
Terry Sernel, $51,053500
NVR Inc.
Yahoo Inc. ratz,
Steven Jobs, Bruce Ka
KB Home
Apple Computer
Len' Frankfort, Robert Toll ,
rs
Coach Inc. Toll Brothe
n,
John Wilder, Paul Evanso
ergy
TXU Corp. Allegheny En
,
Ray R. Irani, Edward Zander
Occidential Motorola Inc.
Petroleum $52,648,142

Source: www.afIcio.orgicorporatewatch/

the strike price equal to the current stock price, the firm never had to report an
accounting cost. Also, the manager can pick the year in which she will exercise the
options and thus determine when the tax liability occurs: In addition, the
compensation was and still is treated as a capital gain, not as income, which is an
advantage to the CEO because capital gains taxes are lower than regular per-
sonal income taxes.
If an executive cashes in for $100 million, this cost does not appear on the
firm's income statement; the firm does not have to report an accounting cost.
However, the economic cost to the firm is real. Consider this simple examph% A
firm has 100 million shares outstanding and has given the executives options for 10
'million shares. The firm currently has earnings of $100 million, or $1 per share. If
the executives exercise their options, then they would buy 10 million shares from
the firm at the strike price and sell them on the stock market. At that point, there
would be 110 million shares outstanding, which means that the $100 million in
earnings becomes only $0.91 per share. The earnings per share have fallen by 9
percent and the firm has become less profitable to its shareholders.
Since July 2005, firms are now required to expense executive stock options
(this is referred to as FAS 123(R)). Even though stock options may have exer-
cise prices at or below the current stock price when they are granted, they are still
valuable. This value, which is estimated using a variation of a formula known
as the BlackScholes option pricing model, is now required to be deducted
later in this chapter.
from reported income, This new regulation will make
exec the granting of
in more detail
utive stock options less attractive, We discuss this regulation
 Periormanze-saresorefer to a company's stock given to executives only. if cet-fr tain
performance criteria are met, such as earnings per share targets. In one sense, these
shares could be viewed as bonuses for past realized performance. If the firm's►l stock price
has increased, then these performance shares are more valuable to the/
EO when he receives them. Performance share plans increased to 20 percent of the.
long-term incentive pay mix in 2004 and was just shy of $1 million for CEOs of large
firms.

INCENTIVE-BASED COMPENSATION' e 1
II 0 K N GENERAL' 7 01■••1.14/11011 0- Y.11111.1.•■■••■•■••■•LAIM MUIII M 71 1=MIM•INPIIII

Tnere are two ways to examine whether or not incentive-based compensation

there is a positive relation between firm
works. First, one could try to see if
ensation. This would be defined as ex postr
,perfoemince and management comp
anagers been properly rewarded for increasing
.'evideric4. In other words, have m
wer is yes, then we could surmise that incentive com-
the firms' value? If the ans
ichael Jensen and Kevin Murphy provide the most
pensation works. ProTessors M
they examined the
well-known evidence tha t the answer is pretty much "no."3 ' total
ver 2,000 CEOs and they found that when the value of
compensation of o the firm
00, then those CEOs were paid $3,25 more on average.
increased by $1,0 Imagine a CEO
takes over a large firm. This CEO would _have Joincrease
who the firm's value b over
$300 million to increase their_compensoi9ub_y_A mere__
$1 million. In academ ic
y that the pay-for-performance sensi
jargon, we Nvould sa tivity is very low.
sess the efficacy of incentive-based compensation is to see
Another way to as if
ted these compensation mechanisms subsequently expe
those firms that enac n
rformance. This could be defined asisS eviclossfi
rienced superior pe
nagers are given incentives, then did the firms subse-
other words, once ma
ll? Intuitively we might expect the answer to be "yes" but
quently perform we
 tIV(3
1 6 c:J. f ARITA 2 gxgettilve InCen
managers are risk-avne,
surprisingly tvidence is mixed, lkI lmon Korn"; Or if a firm relieq
hy should take riA,k57
Melt salaries are already large 30 w
inotr►tives, 1,11/"./1 ;Or, ftfri IT6AfiA••gers Are
he►ivily on, exttetnivc row* option..
takers whf;w the risk sometirneri pays off and sometimes it doe
excessive rifik- lt to rekite firm rAleforrrirInCf.: to not. Tn
addition, note that it in difficu rm well, how cmi we he reliably Sure
»ieni compensa t conirnts, if firms perfo that
ontract had anything to do With the
the incentive-based compensation c firm's
success'?

robierns with Stock Option,Inceatiyoi

There is a good possibility that stock options do not align managerial incentives with
shareholder goals. The following list cites potential incentive problems that
executive options creates:

1. Shareholder returns combine both stock price appreciation and dividends.

The stock option is only affected by price appreciation. Therefore, the Ch .0
might forego increasing dividends in favor of using the cash to try to increase
the stock price.
2. The stock price is more likely to increase when the CEO accepts risky pro-
jects. Therefore, when a firm uses options to compensate the CEO, she has a
tendency to pick a higher risk business strategy.
3. Stock options lose some incentive for the CEO if the stock price falls too far
below the strike price. In this case, the options would be too far underwater
to motivate the manager effectively
4. CEOs may try to manipulate earnings and thus maximize profits in one tar-
get year to make the stock price more favorable for exercising options. This
manipulation can reduce earnings (and consequently the stock price) after
the target year. In other words, managers may try to do what they can to time
stock price movements to match the time horizons of their stock options.
 ,orow
WI kat k‘i

The very a vantage that stock options have oi a igrung manager incentives with

s t o c k h o l d e r g o a l s a l s o c o n s t i t u t e s a ma j o r p r o b l e m . S t o c k o p t i o n s a r e t i e d t o t h e

firm's stock price, which helps align incentives but executives only have partial

influence on stock prices. Stock prices are affected by company perfor m ance but also

by many other factors beyond its control, particularly the strength or weak -

n e s s o f t h e e c o n o m y . Wh e n t h e e c o n o m y t h r i v e s , s t o c k p r i c e s r i s e . E v e n t h e s t o c k

price of a poorly run company may rise, although not as much as its m ore suc-

cessful competitors. This occurrence may richly reward executives of poorly run

firms through their opti ons when they do not deserve them.. Alternatively, the .

stock market m ay fall because of poor economic conditions or investor pes -

s i m i s m . A c o M p a n y w h o s e m a n a g e m e n t o u t p e r f o r m s i t s c o m p e t i t o r s m ay still

find that its stock is falling. In that case, managers should be rewarded but they are

not because their options go underwater when the market falls.

Opt i ons l os e t hei r e ffe c ti ve ne s s whe n t he st oc k pri c e fall s fa r be l ow t he stri ke p rice.

The s t o c k p r i c e d e c l i n e c o u l d b e e i t h e r r e l a t e d t o a c o mp a n y ' s p o o r p e r f o r -

m ance or to a general stock market decline. To re -establish motivation for the

executives, boards sometimes reprice previously issued options and lower the

strike price. Consider th e incentives listed above and how they create interesting

dynamics for CEO behavior. Executives may choose risky company projects that
have a c h a n c e o f d r a m a t i c a l l y i n c r e a s i n g t h e s t o c k p r i c e . I f t h e p r o j e c t s s u c c e e d , t h e
CEO becomes rich and the sto ckholders experience increased w e a l t h . Ho w e v e r ,

i f t h e p r o j e c t s f a i l , t h e s t o c k h o l d e r s l o s e mo n e y . M e a n w h i l e , t h e C E O s i m p l y a s k s t h e

b o a r d t o re p ri c e t he o pt i o n s a n d t h e C E O c a n t h e n re pe a t t h e strategy. Proponents

of option repricing clai m that it is necessary to keep execu -

tives at the firm. This argument has some truth but that does not change the

skewed incentives it causes.

 I

EXAMPLE 2.2

MANAGEMENT'S BEHAVIOR AT XEROX

In a- civil action by the SEC against

Xerox, the SEC claimed senior man-
agement directed a scheme that
improperly accelerated leasing
operations revenue from 1997 to
2000. The accounting maneuvering
increased revenue by $3 billion and
profits by $1.5 billion over that
period. In subse4uent financial
restatements, Xerox shifted out
$6.4 billion of revenue for that time.,
The accounting actions violated gen-
erally accepted accounting practices
and were not disclosed to sharehold-
ers or regulators. Xerox perpetrated
the scheme to meet ever increasing
internal and analyst earnings expec-
tations and it became common for'
Xerox executives to assi n
numerical oals to e produced t
trough accountgin guniiiickry)
-11117eTroth the chic iiiincinri r
cer (CFO) and vice chairman of
Xerox, and the president of Xerox
Europe believed that, excluding
accounting maneuvers, the firm had
essentially no growth in the 199001
 • •

CHAPTER 2 Executive It-iced-laves 19

70
Xerox ex.c.:cuti.,ea seal $48 million worth of '
ortions rind $31 million in other stock.
60 iNT------ ' \ •,., .. :4‘---
50
4J ,' Il
rr

20
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10 jr,,...-v---1.-"•-■-•1-..
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rofits
P6.40 (A phbny p 11'74cc"

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at i 7177,477.71Me 7a7v14.-
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• ,1,A, EfF, • "4 grrireEr r7.4.!4177-737T7PYOirri71177,7,71'4771
e -az twi_kr431.1 0E 4

eawag,,,Ezgagyz...,„att, erESAIII&LO
Several organizations and people have suggested that the cost of stock options
issued to employees and executives should be treated as an expense on the grant-
ing firm's financial statements. Even when option exercise prices are at or below
current stock prices, they are still valuable. The more stock options granted, and the
longer the time allowed to exercise the option, the greater the option value. Using a
variation of a formula known as the Black-Scholes option- tieing model,.
the value of a granted option can be estimated.1 er new re ulation
e I ec ive since 17e*ftfrntirTgrgrartrr • tions- t
from_thelirres "..m.olted income, ome people, e egen ary investor Walreta
u eit,1avebreriTitmoting t is idea for some time. It appCars that there are
three reasons that expensing stock options was being promoted.
The first purpose is to have better disclosure and account for the real cost of
using options as compensation. The expensing would cause the compensatio'n to be
more directly observable to shareholders because it would be reported in the
income statements. Also, the expensing would identify that there is a cost to the
firm for issuing options, As we discussed earlier, there is a real economic cost (i.e.
dilution) to shareholders when executives convert tens, or hundreds, of
millions of dollars in options into common stock and then sell it in the stock mar-
or
ket. Prior to the push for expensing, this economic cost was not well accounted f on
sing
the financial statements of the firm. In other words, this reason for expen
nt.
options argues that the economic cost of options should be more transpare
hat
The second reason for some groups to be proposing option expensing is t it
may reduce the amount of options executives receive and thereby reduce their
 20 e71-1A1)11,P, rxerrtrive inr entivey
on the fe rn tor (Jr ii►►ii")111 rit
lotal comprtimnijottilio mrtlia ►lirni tt►pili ire infr,
dollars ihni tiTeivril Ilan. inte 19900 in `0%Fil
e cost of soli 15 ontifilmitt ottnnt, Y, :11.04
publiciN recording th th 41- t)1.
pay. 111 n11(111100, if e L° °1111"nsi
mu mi
Arc better able to hide their e itri Pia 11 1011 eetilitno , then the tni ii itviy
(qrensed end t hereby refiner% the flrit
not be girlie so p,onrrons in waniing he improgion tlint options
P"Mirig 4104 (Illilt HIS is t
.111e trivIon for eX s rls tit s41Btg1kils, That is,
owned )5 anti other e.xrCIllivc OM led to eorpo
eitly,
CXCC.ItiVeff it IIIVI:111110111 fear bri►tlfitil►f! from using, neeour
options Wive rice of the con IlInny stock, If options 3re,
chicanery to artificially pi►►p lip the p
ybe there wail be 1031► of an incentive
not as attractive for firms to issue, thee ma for
executives to time the mnrket.
ot represent an env and at tom,. tic
However* the expensing of options might n
IOCk Some industries, like
solution to the problems inherent in executive B y employees, not jus xecutives.
technology, use options as compensation for man te For
ts employees. indeed, twiny
example, Microsoft issues options to most of i
ew FASI3 regulation." Even
technology firms are adamantly opposed to the n some
d lower managers, like
non-tech companies use options to pay middle an
stert,up companies to
'obis Corp, a department store chain, Also it is common for
low $13
partially pay employees in stock options to help compensate for 1uries.
f
Using this type of pay system, the young company can conserve one o most precious
resources, cash, and motivate employees to work hard, What happens to these
compensation systems if options are expensed? The reduction in reported earnings
may cause the companies to curtail option programs. This could inhibit the growth of
new companies. It could even have tin irtlpEla on the economy since new companies
are an important source of new jobs.

tinCOMMISAT1ONI
 CHAPTER 2 Executive incentives 21

dhomes: Wells Fargo CEO Richard Kovaeevich borrowed $1 million for a honown
pay at
ment.The savings on low interest loans can quickly add up to tens or hun

-
dreds of thousands of dollars. Frequently, executives do not even pay back the
loans. Mattel Ccap. absolved ousted CEO Jill Barad from repaying a $7.2 million loan
and then paid her an adili Lima] $3,3 million to cover, the cost of resulting addi-
tional taxes. 14 The new CEO, Robert Eckert, received a $5.5 million loan and will not
have to repay it if he stays with the firm for two yaars. A similar arrangement exists
with Compaq Chairman and CEO Michael Capellas for his $5 million loan,

Earlier, we stated that managers will work hard on behalf of shareholders if they are
carefully monitored and if they have the right incentives. Moat of this book discusses
monitoring.This chapter has discussed manaserial incentives. _ However perhaps a
third way tv align thTTregETIWrcirinVieis with srarefioldera is to
e penalty formangers who intentionally anidilcrt
behave irri,Tiys-th-it'ilie not beneficial to'sharcholders.
I_Trider the new Sarbanes-Oxley Act, the firni's executives now have to sign off
certifying the appropriateness of the financial statements. In addition,„ehe4ct
incre'ised the scope and penalties for white-collar crimes. rriXtly 2005, Bernie
ers, f3iinTrrail atereirec:lrir767:WiTriMom, was se n tenCe d
,25 ears ip..:1)11S0r1 for. his involvement in Wejleelcaria:a$4billion„aspeoimatiagizaake.
"the iii � is writing, TAinis Kozlowski, former CEO of Tyco, is -awaiting
sentencing following his guilty verdict of grand larcencHEuaajnst.Tyco. Will punish-
misbehavior? Time will tell.
ment serve to deter managerial But it is often the case that
etter motivators than "sticks" or punishment.
"carrots" or rewards are b

AL PERSPECTIVE — EO COMPENSATION
INTERNATION C
ORLD eastAt)
AROUND THE W
fficer in the company with long-term incentive awards is OSE
Paying the top o M
the compensation of CEOs around the world,
common in the U.S. Figure 2.2 shows split
gories. nese categories are fixed pay (base salary and benefits),
into three cate variable pay
entive-type instruments like stock options), and perquisites. •[he
(inc data comes from
surveys conducted by Towers Perrin.° 1 he figure shows that
erage, of a U.S. CEO's pay is vai fable in nature.
63 percent, on av
component of CEO pay s uch higher in the U.S. than most
The variable i m other
nly Singapore (59 percent) and Canada (52 percent) have sim
countries. O ilar fractions
variable pay. In contrast, CEOs rom any countries earn most
or f m
ation from fixed pity. For example, for CEOs in China (except
of their
compens Hong Kong)
9 percent of their compensation is fixed. The percentages for
7
 lgium are 73 percent and 73 percent, respectively. Variable pay is
Sweden and Be at
ent of total compensation for only fi of the 23 countries, India,
least 50 perc one of the
untries with less than 50 percent composition in fixed pay, pays
five co